Friday, March 18, 2016

Markets Defying Central Bankers?

Efforts by many of the world’s central banks to weaken their currencies are failing, raising concerns about whether policy makers are losing the ability to wield control over financial markets.

This was the case again in Japan on Thursday, when the dollar fell 1.1% against yen, to ¥111.39.

Despite the Bank of Japan’s efforts to push down its currency and jump-start the economy with negative interest rates, the yen is up 8% this year and is at its strongest level against the dollar since October 2014. European central bankers are having similar problems containing the strength of the euro and other currencies.

These difficulties are a reminder that the long stretch of exceptionally low rates in response to the 2008 financial crisis has created market distortions that may be difficult for central bankers to contain.

This disconnect could produce more volatility in financial markets. Even if investors can predict what actions central banks are likely to take, they are having a hard time predicting how markets will react, potentially sparking a pullback from riskier assets, such as emerging markets or commodities.

It also underscores long-standing concerns about the prospects for global growth. A number of central bankers are reaching for the lever of lower interest rates to weaken their currency and make their exports more competitive. But because policy makers are all following the same approach, they are in effect canceling each other out.

“There is a rising concern that central banks are testing the limits of their policies,” said Brian Daingerfield, a currency strategist at RBS Securities. “Each time you take a tool out of the tool kit, it gets closer to being empty.”

Even some central banks with less actively traded currencies are having a hard time guiding markets. Norway’s central bank on Thursday cut its main interest rate to a record low of 0.5%, and a bank governor said he wouldn’t rule out negative rates, in which central banks charge big lenders to hold deposits. The Norwegian krone gained more than 1% against the dollar and was up against the euro.

Lower interest rates in the past have had the effect of making a currency less attractive to hold as investors seek out higher-yielding assets.

Even some central banks with less actively traded currencies are having a hard time guiding markets. Norway’s central bank on Thursday cut its main interest rate to a record low of 0.5%, and a bank governor said he wouldn’t rule out negative rates, in which central banks charge big lenders to hold deposits. The Norwegian krone gained more than 1% against the dollar and was up against the euro.

It wasn’t that long ago that actions, or even the hint of future action, from most of the major central banks had a powerful effect on their currencies.

Japan Prime Minister Shinzo Abe promised unprecedented monetary easing upon taking office in late 2012, looking to kick-start growth and spur inflation. Mr. Abe’s handpicked head of the Bank of Japan flooded the economy with cash by kicking off a bond-buying program. The yen fell 37% against the dollar from October 2012 to June 2015.

Central bankers also used policy or moral suasion to strengthen their currencies. In 2012, Greece suffered the largest government debt default in history, leading many analysts to question the future of the European monetary union. ECB President Mario Draghi pledged to do “whatever it takes” to preserve the euro. His determination soothed investors and stopped the single currency’s tailspin, boosting it to an 11% gain against the buck in six months.

But as the long period of rock-bottom rates continued, that influence has looked like it is fading. While the ECB’s initial move to cut interest rates into negative territory in June 2014 sparked a sharp plunge in the euro, further cuts last December and last week have had little effect on the currency.

“The ECB’s hand has been played out,” said Alan Ruskin, head of G-10 foreign-exchange strategy at Deutsche Bank AG . “The currency market isn’t as responsive to the ECB anymore.”

Similarly, markets have ignored the Bank of Japan’s hints at its monetary-policy meeting this week of more rate cuts to come. Not only has the mechanism transmitting ultraloose policy into the real economy appeared to be broken, but some unconventional policy tools—such as negative interest rates—have been deleterious to banks and rattled financial markets.

“Banks get squeezed and savers are inadvertently encouraged to hoard cash or, worse, encourage bubbles by forcing money away from the safety of government debt and into other markets regardless of fundamentals,” said Anthony Cronin, Treasury bond trader at Société Générale SA .

A number of government bonds are yielding below zero in places like Japan, the eurozone and Switzerland. Money managers said this has added to concerns that central banks are distorting the normal market function and that investors are finding it difficult to fairly value financial assets.

Analysts said central banks need to pay attention to the unintended fallout on markets and banks from tools such as negative interest rates. Mr. Draghi signaled hesitance to cut rates deeper into negative territory this month, while Ms. Yellen said this week that Fed officials aren’t “actively considering negative rates.”

Still, some market participants warn it may be too early to judge whether central-bank policies are losing effectiveness.

Donald Ellenberger, head of multisector strategies at Federated Investors, which had $350 billion in assets under management at the end of December, said central banks “have proven remarkably creative devising ways to use monetary policy to try to stimulate the economy.”

He cited the latest stimulus from the ECB on March 10, with the central bank adding nonfinancial corporate debt to their bond-buying list. The move has fueled a rally in corporate bonds and sent yields falling, which helps lower corporate borrowing cost.

“Central banks are experimenting in real time,” he said. “There is no lab for them to practice in.”

I've long argued that central banks will do whatever it takes to stave off the global deflation tsunami headed our way. But I've also warned that all central banks can do is buy time. Ultimately its fiscal policy that is needed to fix global stagnation, a point former Fed Chairman Alan Greenspan underscored in a recent Bloomberg interview (see below).

Getting back to currencies, Zero Hedge states the best summary of just how confusing it all is comes from BofA's Athanasios Vamvakidis who writes the following:

If FX is the messenger, the message is not clear.

The FX market is confusing this year. More easing by the BoJ, the RBNZ, the Riksbank, the ECB and the Norges Bank, led to stronger currencies, despite delivering more than markets had expected in all cases. The market seems to be taking recent monetary policy easing as evidence that central banks are reaching their limits, as their forward guidance has sent mixed signals. We disagree in the case of the ECB, but are more sympathetic in the cases of the BoJ and the Scandies. A surprisingly dovish Fed this week added to the confusion, by ignoring the latest improvement in US data and better global market conditions. The market moves would be consistent with EM central bank interventions, as the time zone analysis in our quant section would suggest.

However, we do not believe that this is sustainable. In our view, the more counterintuitive the market moves, the sharper the correction during the inevitable reality check.

So what is going on? Why are global currencies rallying relative to the USD and are central banks reaching their limits?

On Thursday, I had an interesting discussion on this topic with my buddy in Toronto who has been trading currencies for almost 30 years and is one of the few people I know who actually makes money trading currencies.

"I just want it noted for the first record that both my ranges were met: 1.30-1.45 $. And I really hope those pension funds that were sitting long USD/CAD read your blog when they were told to hedge at 1.45. A quick 12% maybe that even beats their annual rate of return."

He also told me "The Pound Sterling is very cheap and Canadian pensions shouldn't be concerned of Brexit. It won't happen as Germany will give a lot of concessions to Britain but this will cement the end of the Eurozone in the future because you can't have favoritism in a monetary union."

Like I said, when it comes to currencies, my buddy prints money. He told me he ignores extremists like that Australian economist who earlier this year warned the loonie will reach an all-time low of 59 cents by the end of 2016 but agreed with me that the recent rise of global currencies relative to the USD won't last:

"The way to think of currencies is the U.S. relative to the rest of the world. The U.S. leads the global economy by six to nine months. Go back nine months when the U.S. economy was doing well and its currency was rising. Now you see signs of the U.S. economy cooling and rallies in the euro, yen and emerging market currencies but I agree with you, it won't last. It's all part of a global RISK ON trade that will peter out and the greenback will once again start rising relative to other currencies."

So what's going on? No doubt, a lot of short covering took place after the announcement but if you ask me, the euro is doing a yen and rising because the ECB once again disappointed markets just like the Bank of Japan did when it adopted negative rates on January 29th.

And the biggest nightmare of all in Europe? State pensions. There is a demographic and pensions crisis unfolding in Europe, exacerbated by the ongoing jobs crisis, and it's a slow motion train wreck that will decimate public finances there.

I also added this:

[...] and you can keep shorting the CAD, Aussie and Kiwi on any strength too. Global deflation is coming and I think markets are going to sell the latest Mario Draghi "bazooka" really hard.

So why am I so convinced? Because nothing has fundamentally changed in the world. Deflation is still ravaging China, Japan and the Eurozone and if the Fed isn't careful, deflation will come to America via much lower import prices.

What did the Fed's decision do? It weakened the U.S. dollar and sent commodity prices (in particular oil prices) higher and it loosened financial conditions in the United States (but tightened them elsewhere). This is what the Fed wanted as a lower USD means higher import prices and higher commodity prices which will stoke U.S. inflation expectations higher.

This also helped boost risk assets around the world like emerging markets, commodity and energy stocks and commodity currencies. You will notice that since late January, emerging market currencies and stocks (EEM), commodity currencies like the Canadian (FXC) and Australian (FXA) dollar, and Energy (XLE) and Metal and Mining (XME) shares have all rallied sharply.

Some of these stocks like Freeport-McMoRan (FCX), Teck Resources (TCK), and U.S. Steel (X) have more than doubled since hitting their lows in January but I warn you, the big money has been made and this will turn out to be the biggest sucker rally of the year.

Go back to read my comment going over top funds' activity for Q4 2015 where I warned you to stay away from the Valeant (VRX) hedge fund hotel and stated the following on energy and commodity stocks:

Given my outlook on global deflation and the new negative normal, I still recommend investors steer clear of energy and commodity names, but as I keep saying, there will be strong, tradeable countertrend rallies in these sectors and on specific stocks.

If you think the recent plunge in Valeant's shares was bad, wait till you see the plunge in many energy and commodity names after this countertrend rally fizzles (many of these stocks will retest their lows; just look at the recent action of Peabody Energy). It will be brutal and many institutional and retail investors will get slaughtered.

And the same goes for all these commodity and emerging market stocks and currencies. Their appreciation relative to the USD, just like that of the euro and yen, won't last for long.

In fact, have a look at this chart of the EUR/USD (click on image):

Euro bulls will tell you it's getting ready for a major breakout but I doubt it will go over its 400-day moving average and I think it's a screaming short at these levels.

One final remark. These are very brutal and volatile markets and I warn all of you, it won't get easier for the rest of the year. Beware of hedge fund managers who tell you "the market is wrong" as they will be humbled by this market.

And for all of you buying this global recovery story, I have one question for you: Why isn't the bond market worried?!? (click on image):

The recent drop in U.S. long bond yields is telling me the bond market isn't buying the global recovery story and it's still worried about global deflation. It's also telling me that the USD will start rallying from here to the rest of the year as global investors seek refuge in good old U.S. bonds.

On that cheery note, I wish you all a great weekend and remind you to please subscribe and/ or donate to this blog at the right-hand side under my picture. I work hard to provide you with great insights on pensions and investments and appreciate those of you who support this blog via your dollars.

Below, former Federal Reserve Chairman Alan Greenspan discusses the global economy and central banks monetary policies. Listen to the Maestro, he's dead wrong on the bond market but he's right that "stagnation is a fiscal problem, not a monetary problem" and that we have a "productivity problem."

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I am an independent senior economist and pension and investment analyst with years of experience working on the buy and sell-side. I have researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). I've also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system. You can follow my blog posts on your Bloomberg terminal and track me on Twitter (@PensionPulse) where I post many links to pension and investment articles as well as my market thoughts and other articles of interest.

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